Great Depression Online Archive Issue:

A Run-in with a Wise Elder

Great Depression Online
Long Beach, CA
April 21, 2009

Inside This Issue You Will Discover…

*** The Impossible Happened
*** Economic ‘Tough Love’
*** A Run-in with a Wise Elder
*** And More

The Impossible Happened

About the time Elvis Presley choked on his last pill, the impossible happened…inflation and unemployment simultaneously went vertical.  Leading economists of the day were flummoxed.  The Philips curve had told them there’s an inverse relationship between inflation and unemployment. 

How could it be that both were going up at once?

Of course, it took years of government tinkering to pull off such a feat.

In short, when unemployment began creeping up in the 1970’s the U.S. Treasury, with backing from the Federal Reserve, did what Keynes had told them to do…they spent money in the hopes of creating jobs.  But instead of jobs, something unexpected happened; they got inflation.  And when they tried it again, astonishingly, they didn’t get jobs…they got more inflation.

By the time Jimmy Carter left the White House, the Misery Index, which is the sum of the Unemployment rate and the Inflation rate, was rocketing toward 20 percent.  And only when the Country was firmly stuck in the quagmire of stagflation, was the brain trust finally willing to listen to Milton Friedman…a man whose ideas they’d rejected in the 1960’s.

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Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.”  What he may have meant is that increasing the money supply at a faster rate than economic growth is, in fact, inflation; higher oil prices or wage increases can sometimes be the consequence, but they aren’t the cause.  So to end inflation, Friedman explained, economic policy should tighten up the money supply.

This went counter to the Keynesian zealots at the time.  For tightening the money supply would be the death blow to an economy already staggering with high unemployment.  

Economic ‘Tough Love’

In August of 1979 Paul Volcker took the helm as Chairman of the Federal Reserve.  No time before or since has the Federal Reserve been Chaired by a man who did other than the politically expedient.

Volcker talked tough and acted tougher.  He recognized that before economic growth could return the inflation fire must be snuffed out…even if doing so meant higher unemployment in the short run.  In the face of a wave of criticism, which included being burned in effigy on the Capital steps, Volcker implemented Friedman’s policy of economic ‘tough love’.

Volcker raised the federal funds rate from 11.2 percent in 1979 to a peak of 20 percent in June 1981…sending the prime rate to 21.5 percent in 1981 and the economy into a severe recession. 

Remarkably, for two long years, as rates went up, inflation did too. 

But, finally, in 1983, inflation was controlled.  Soon after, economic growth returned, unemployment fell, and the United States enjoyed 25-years of near uninterrupted prosperity.

A Run-in with a Wise Elder

Economics is a dismal science, they say.  And taking the right action doesn’t immediately correct an economy that’s been retarded by years of wrong actions.  Conversely, taking the wrong action doesn’t often express itself in the economy until it’s too late.

Last Saturday, Donald Kohn, Vice Chairman of the Federal Reserve, a man convicted in his belief the Federal Reserve is taking the right action, had a run-in with a wise elder.  Here’s the recap from the Wall Street Journal…

“Federal Reserve Vice Chairman Donald Kohn’s question-and-answer session at a Vanderbilt University conference Saturday was going as countless others surely have in his years as a top policy maker.

“Until Paul Volcker raised his hand.

“Then, Kohn was grilled over the Fed’s apparent effort to convey that it considers a roughly 2 percent inflation rate to be appropriate for the economy in the long term.

“Former Fed Chairman Volcker, who along with Kohn was at a conference honoring former Fed governor Dewey Daane, questioned how the Fed can talk about both 2 percent inflation and price stability.

‘“I don’t get it,’ Volcker said, leading to a lively back-and-forth between the two central bank heavyweights.

“By setting 2 percent as an inflation objective, the Fed is ‘telling people in a generation they’re going to be losing half their purchasing power,’ Volcker said.  And if 2 percent is the best inflation rate, and the economic recovery lags, does that mean that 3 percent becomes the ideal rate, he asked.”

A very good question indeed.  A question we believe will be asked again of the Federal Reserve as the economy progresses into the next phase of the depression, which could very well include the return of stagflation.

Sincerely,

M.N. Gordon
Great Depression Online

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